Deflation Threat In Europe May Push Investors Out Of Stocks

LONDON (Reuters) - The threat of deflation in the euro zone could
reverse a major investment trend of 2013, drawing funds out of
stocks and into government bonds and cash.

Europe is still some way
from a negative inflation rate, let alone a Japanese-style
deflationary spiral - the policymakers' nightmare in which falling prices weaken demand, leading
to wage cuts and even lower prices.

But a warning light is already flashing, with euro zone inflation
registering a shock drop last month that prompted an interest
rate cut.

This year's "Great Rotation" flows away from bonds have propelled
many stock markets to multi-year or record highs and fuelled a
rally in property and other
relatively high-yielding assets.

But it's a potential money loser in an environment of weak inflation or even
outright price declines. With chronic price falls, investors
become ultra-risk averse.

"Deflation would follow from lower
growth than we currently have. It would increase the attraction
of fixed income versus equities," said Jan Loeys, JPMorgan's head
of asset allocation.

There is certainly scope for equities to pull back. The S&P
500 <.SPX> and Dow Jones Industrials <.DJI> have hit
record highs in recent weeks.
Germany's DAX <.GDAXI> has hit a five-year peak and Japan's
Nikkei <.N225> is up 37 percent this year.

According to Bank of America-Merrill Lynch, who coined the "Great
Rotation" phrase, global equity funds have attracted $231 billion
of inflows this year. Bond funds have pulled in just $16 billion, and have posted outflows
in12 of the past 14 weeks.

Now comes falling inflation. In
the euro zone, it slowed to just 0.7 percent last month, well
below the European Central Bank's target of below, but close to 2
percent. The ECB halved interest rates to a fresh low of just
0.25 percent as a result.

And if inflation falls further, the ECB could act again. This
puts it on a potentially divergent path from the U.S. Federal
Reserve, which most observers say will begin the process of
removing its policy stimulus in
the coming months.

VULNERABLE FINANCIALS

Deflation alone is not seen as an
outright negative for equities, which can still rise if there is
moderate growth.

But in such an environment,
financial stocks tend to underperform because deflation increases a borrower's real debt
burden, contributing to higher non-performing loans and lower net
interest margins for banks as the gap between short- and
long-term interest rates narrows.

"If we get a deflation psychology
beginning to break out inEurope you have to
reconsider the relationship between a 'risk' asset and 'non-risk'
asset," said Bill O'Neill, chief UK investment strategist at UBS
Wealth Management.

"Markets will be focusing on assets that provide nominal
guaranteed returns such as government bonds. You would want to be
aware of risks in equities,
in particular in financials."

Investors may already be wary of such risks. European financial
stocks <.SX7P> have fallen 1.5 percent this month, making
them worst performing sector inEurope.

European banks are shrinking their balance sheets as they adjust
to new, tighter regulations on risk-taking and capital, as well
as drastically weaker demand for loans due to the brittle economy
and record high unemployment.

The deflationary force of this deleveraging is powerful. As banks
lend less, credit creation slows, and so does spending. Morgan
Stanley reckons European banks shed 3 trillion euros of assets
in the last year, with 1 trillion
of that going in the second
quarter of this year alone.

If financials are among the most vulnerable stocks, high quality
euro zone exporters may be best positioned, assuming deflation remains confined to the euro zone.

"It's all about pricing power," said Nick Samouilhan, fund
manager in the multi-asset team at
Aviva. "But equities would not be where you generally want to
be," he said.

Preferred investments would mostly be cash or government bonds,
even taking into account the dynamics in a deflationary environment.

Inflation reduces the value of money, lowering the real value of
a borrower's debt and the real value of a saver's savings.
Inflation tend to be good news for borrowers, but bad for savers.
The opposite is the case with deflation.

In times of low inflation or
deflation, cash and government
bonds are relatively "safe" assets that protect an investor's
capital and ensure a fixed - if low - rate of return.

Within that universe, higher-yielding "peripheral" euro zone
debt, such as Spanish and Italian bonds, may be the best bet now
that investors have almost priced out default risks.